For the second piece in our Explainer series we’re looking at bad debt and loan defaults. We’ll describe what these terms mean from an investor point of view, then look at how you can reduce their impact and still earn a good return at Funding Circle.
What is a loan default?
A loan may be defaulted when a business is late in its repayments, has entered insolvency or has otherwise breached the terms and conditions of the loan. The remaining balance and interest is then demanded from the borrower and loan guarantors.
We’ll take the decision to default a loan if we think it’s necessary to protect the interests of investors. In some circumstances defaults are mandatory.
What is bad debt?
When a loan is defaulted, bad debt is the money potentially lost by investors. This amount may be reduced during the recovery process (more on this below).
Why do they happen?
Businesses fail for a wide variety of reasons. The most common causes are cashflow (i.e. customers not paying on time, or creditors demanding immediate repayment), increased competition, losing a large contract, illness of the business owner or key workers, and regulatory changes making the business non-viable.
Consequently, a few of the businesses you lend to will be unable to fully repay their loans. We estimate that you should expect a bad debt rate of around 2.0% of your investment annually, although this will vary by the risk bands (A+ to E) you lend to.
How do we account for them?
As defaults are a known risk, we take them into account when setting interest rates. Our credit assessment team perform rigorous checks on all businesses and if we estimate a business is higher risk, they pay a higher interest rate to compensate.
For each risk band, the money lost on loans that default is balanced by the extra interest paid by those that repay. As long as the bad debt rate stays within expectations, investors can still earn good returns. That’s why when we give an estimated return, we give you the figure after bad debt and fees.
Reduce the impact of bad debt with diversification
Diversification is a simple way to help reduce the impact of bad debt on your investment. Diversifying means splitting your investment into lots of small pieces, and lending them out to different businesses.
- Without diversification – As an example, say you have £2,000 in your Funding Circle account. If you lent that all to one business and they defaulted on their loan, you could lose all of your money in one go.
- With diversification – Instead, if you were to split your £2,000 across 100 businesses, you could then lend just £20 to each. Then if one or two of them defaulted, you would only lose £20-40. You would still earn interest from the other 98 businesses you’ve lent to, so would still have a great chance of earning a good return overall.
How to diversify
A great way to earn a stable return is to lend to at least 100 businesses, and lend no more than 1% of your total to each one. As of 16 Feb 2017, every investor who has followed these two steps has earned a positive return, and 91% have earned 5% or more (after fees and bad debt) after being diversified for a year. You can diversify automatically by using our Autobid tool.
Learn more about diversification here.
Collections & Recoveries – helping recover as much as possible for investors
Almost all Funding Circle loans are supported by a personal guarantee from company directors (property loans can differ). If a business is unable to repay the loan, our team can look to recover the outstanding balance from the guarantors.
Our Collections & Recoveries team pursue every single defaulted loan, arranging a new payment plan if possible, or exhausting every legal process available. The team has a range of methods and technologies in place to recover as much as possible for you.
When a loan defaults it will show the total loss on your account. However, our team are often able to recover a significant portion of that loss. As of February 2017, they have successfully recovered 44% of defaulted loans taken between 2010-2014, so it’s worth remembering that the amount “lost” on any recent defaults may improve over time.
The success of the team’s approach led to them winning the 2015 CICM Best Collections Team and 2016 Credit Excellence Award for Collections from CCRI.
You can read more about our Collections & Recoveries process here.
Things to remember
Hopefully now you have a better understanding of bad debt and defaults. Here are a few key points to remember:
Bad debt is inevitable, so be prepared for a small percentage of loans to default. It’s baked into our interest rates, and if you diversify you’ve still got a great chance of making a good return.
Splitting your investment across 100+ businesses, with no more than 1% lent to each one, reduces the impact of any defaulted loans.
We’ll help you out
Our Collections & Recoveries team will work to recover as much of the debt as possible, but this will take time. They will update you on late and defaulted loans through your Funding Circle account.
Of course if you have any questions our Investor Support team are on hand to help, and can talk you through any activity on your account. You can call them on 0207 401 9111 or email email@example.com.
As of 6th March 2017 our estimated return after bad debt and fees is 6.9%. If you’d like to invest through Funding Circle you can set up your account here.
It is important to remember that past performance is not a guide to future performance, and your capital is at risk when lending to businesses.